What Is Amortization and How Does It Work?

Key takeaways:

Amortization is the process of mapping out the value of a loan over a period of time.
Financial institutions create loan amortization schedules to help borrowers understand their loan repayment plan for the duration of the loan.
You can manually calculate your amortization schedule using a formula, or you can use an amortization calculator.

Amortization is a technique used to break down the value of a loan over its repayment schedule.

In this article, we’ll discuss why amortization is important, what types of loans can be amortized, and how an amortization schedule works.

What is amortization?

As we mentioned above, loan amortization is an accounting technique documenting what you’ll owe for a set period of time. Although monthly payments remain the same over the life of an installment loan, the way each payment is divided between principal and interest will change.

Pro tip: Amortization can also be used for intangible assets like copyrights, patents, and customer lists for accounting and tax purposes.

Why is amortization important?

As it relates to loans, amortization is important because it provides individual borrowers and small businesses with a clear, set payment amount consisting of both the interest and principal payments.

This can provide a more manageable repayment schedule. It can also help borrowers strategize ways to pay down their debt faster, such as making additional payments on the principal balance.

Amortization is also useful for other financial purposes, like deducting interest payments for your taxes, which lowers the loan amount you owe.

Types of amortized loans

There are many types of loans, but they don’t all function the same way. Some common types of installment loans that can be amortized include:

Home loans (aka mortgage loans): Mortgages typically have 15- or 30-year fixed rates and come with a fixed amortization schedule. However, you can also get an adjustable-rate mortgage (ARM). With this type of mortgage, the lender can adjust the interest rate on a fixed schedule, which may change your amortization schedule.
Personal loans: With personal loans, you can use the funds for almost any big expense you have. They typically have fixed interest rates and monthly payments.

Financial products that don’t get amortized

Not all loans get amortized. Some examples include:

Credit cards: A credit card is a revolving line of credit, which you can use to continuously borrow funds. Instead of a fixed monthly payment, you can choose if you’d like to pay back just the minimum payment or contribute more to the balance.
Balloon loans: A balloon loan is a mortgage loan with a short repayment term. When people take out money for their mortgage, they typically have a large balance to repay. Unlike some loans, balloon loans don’t amortize.

This means the monthly payments through this term are not organized to help the borrower pay off the entire balance by the end of the repayment period. The monthly payments for a balloon loan are divided as if the loan is a 30-year mortgage.

Given that borrowers with this type of loan don’t have enough time to pay off the loan in full, they’ll make a “balloon,” or a big, payment at the end of the loan.

Personal line of credit (PLOC): A PLOC is a type of unsecured personal loan that partially amortizes. With a PLOC, borrowers get a set amount of money from which they can borrow for a set period of time, also known as a draw period.

Similar to a credit card, you can take out the amount you need from the available balance. Additionally, borrowers only pay interest on the amount they take out. Once the revolving draw period is over, it’s followed by a fully amortizing repayment period for the rest of the loan term.

What is a loan amortization schedule?

An amortization schedule is a thorough breakdown of your monthly loan payments. Depending on the type of loan you get, your lender may provide an amortization schedule to help you understand your loan repayment schedule.

If you’d like to try and calculate your amortization schedule yourself, you can use the formula below to calculate the monthly principal:

Principal payment = total monthly payment − (outstanding loan balance × interest rate/12 months)

With an amortization schedule, you can understand:

How much interest you’ll pay over the life of the loan
The amount of interest versus principal you’ll owe each month
The remaining loan balance at the end of each month

Pro Tip: Although you can use a few formulas to calculate the payments for each month of your amortization schedule, we highly recommend using an amortization calculator instead.

Amortization schedule example

To put it into perspective, let’s say you take out a four-year, $40,000 personal loan with a 6% interest rate. Your monthly payment is $939.40. The total interest over the life of the loan is $5,091, and the total for 48 months of payments is $45,091.

The first year of payments for your amortization table would look like this:

Number of payments	Total payment	Interest payment	Principal payment	Balance
1	$939.40	$200	$739	$39,261
2	$939.40	$196	$743	$38,518
3	$939.40	$193	$747	$37,771
4	$939.40	$189	$751	$37,020
5	$939.40	$185	$754	$36,266
6	$939.40	$181	$758	$35,508
7	$939.40	$178	$762	$34,746
8	$939.40	$174	$766	$33,980
9	$939.40	$170	$769	$33,211
10	$939.40	$166	$773	$32,437
11	$939.40	$162	$777	$31,660
12	$939.40	$158	$781	$30,879

By calculating your amortization schedule, you can see the value of each of your monthly payments compared to the balance of the loan.

The bottom line

Calculating or reviewing your loan amortization schedule can help you understand exactly how much you’re paying and when it’s due. You can also compare the amortization schedules of different loans you’re considering to ensure you’re selecting the right one.

Additionally, if you’re trying to pay down multiple debts, you can use the amortization schedule as a guide to help you understand which payments to focus on.

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What is Amortization and How It Works